Market Efficiency: A Glaring Oversight In Passive Strategies

Passive investors have been allowed to define active investing for active investors. I want to even out the discussion from an active investor’s perspective.

How Passive are Passive Investments?

Let’s first call into question whether passive investing is really passive investing. We’ll start with the American S&P 500 index.

Unbeknownst to many investors, the S&P500 index is picked by committee. This sounds somewhat active, but I am willing to let it slide for now. The index includes “the most widely-held” companies on the US exchanges. Seeing as active management controls the majority of funds on the market, the S&P 500 holds the stocks active investors prefer.

The same is true with Canadian indexes. Take the S&P/TSX 60, an index that frequently appears in passive investors’ portfolios. The index holds the 60 largest stocks by market capitalization. The largest stocks by market cap are, by necessity, stocks owned by most active investors.

Thus, passive indexes are propelled by active managers. The difference between active and passive funds is the cost – holdings are virtually the same by nature of how the indexes work.

Taking Research too Far

I have no problem with any claim that the average actively-managed mutual fund will lose to passive portfolios. The market indexes and all active managers essentially hold the same stocks. Active managers charge higher fees for largely the same exposure – naturally active managers underperform. This isn’t rocket science. If investments are the same, the lowest fee fund wins.

Passive investors have taken this debate too far, however, to conclude that no one can beat the market averages over a long period of time. Something must be said of “academic” research into the matter…if “academic” researchers were to find a way to beat the market, they probably wouldn’t be academics any more. But I digress…

Here’s the thing: there is a very fundamental difference between mutual fund managers and individual investors. There are liquidity requirements, diversification controls, and a slurry of rules and business realities that push institutions to favor a portfolio that looks much like a broad market index.

But most importantly, individuals do not manage large portfolios.

You Don’t Have $1 Billion

Passive investors like to say that since well-trained portfolio managers from Ivy League schools cannot beat the market, the individual investor absolutely cannot.

But there are really two different stock markets.

There’s the market professionals participate in – firms with market caps of $1 billion or more. Then there’s the market that professionals do not touch – firms with tiny market caps of less than $1 billion.

Right now, 50 analysts watch Apple’s every move. 50 people – there is very little wiggle room for an independent thinker to do better. Apple is just one company, though, and there are 3,100 other companies with absolutely zero analyst coverage. Nearly one out of every three listed companies opens new stores, builds new factories, or reports earnings without a single professional listening to the news coming from the company.

As for who is doing the buying and selling in these small companies, it’s almost entirely individual investors and occasional rebalancing action from an index fund. Brainless indexes making rules-based transactions, and individual investors with no real training in securities analysis, are not a market that lends itself to efficiency.

Some Examples

This post would be nothing without proof of the opportunity available in small companies – companies too small to attract professional asset managers. In the past few years I’ve found several high-quality companies hiding in the micro-cap segment of the market. I just had to look.

One was a health care company by the name of Metropolitan Health Networks. It consistently increased profits, cut expenses, and traded at a very, very low multiple to its forward earnings. It wasn’t until the company, worth $200 million in the first half of 2011, purchased another company that it attracted the attention of Wall Street analysts and mutual fund investors.

Sharks are hard to find until there’s blood in the water, but they come quickly when blood appears. From October 2011 to June 2012, top mutual fund shareholders (almost entirely new funds that never had an interest in the company) increased their stake by 300%, and the stock rallied by 109%. Nothing of material importance changed in that time – the company simply landed on the radar of more qualified investors.

I should note that MDF’s acquisition was of another company in my portfolio at the time, CNU. It was valued at roughly $300 million, and MDF paid a 30% cash premium plus shares for the firm before the combined entity rallied considerably. I was essentially paid twice on the transaction – once in the buyout, and once more when the combined firm attracted institutional investors. It just goes to show how much inefficiency can be found in smaller firms.

These aren’t risky, speculative pharmaceutical stocks, mind you. They provide basic medical services to patients with a particular insurance company. But because of their size, and size only, Wall Street had yet to go looking for them.

Another company is an excellent case for market irrationality. For several quarters over the course of two years it sold for less than net working capital. You need zero financial experience to know that purchasing a profitable company for $1 million when it has $2 million in the bank is a very good deal. A golf company, Adams Golf would later sell out to Adidas for a 127% return in 17 months. Those that got in even earlier saw 2 year returns of 200%.

The buyer? A giant in the space – Adidas!

The Key Detail

All of these companies were worth less than $250 million at the time of my investment. They’re “too small” for institutional investors – professionals. Few portfolio managers could justify watching a $250 million company when they have billions of dollars to manage. Thus, information is “priced-in” by people who have limited academic or experience-driven expertise.

For ordinary people like you and me – people who do not have billions of dollars to move around – these market caps are more than adequate. And it is in this inefficient market of smaller companies that individuals have the greatest edge on professionals because there are no professionals to beat.

In short, the biggest companies are usually very rationally priced. There is a very efficient market for shares in Apple or Exxon Mobil. Assuming all of the market is rationally priced, however, is to completely ignore that more than one-third of all listed securities are not even on the radar for institutional investors. That detail alone should discount entirely the belief that the markets are always efficient, and that out-performance can come only from greater risk.

11 Comments

JT McGee and Ed Rempel are the only two people I have ever seen that put forward rational, persuasive arguments in favour of active investing. Here are my responses (as a huge passive investing advocate) to JT’s points which are all correct to some degree btw.

1) I prefer larger indexes than the S&P 500, but your point is valid. That being said, opting to take the average after all of the sharks on Wall Street are done duking it out is a much better option for most than trying to compete against them.

2) You are absolutely correct that opportunities exist in the micro-cap sector. If you are the Money Mamba and are comfortable doing all of your own extensive research and taking the huge amount of risk that is part of the growth-oriented micro-cap world. The VAST majority of individual investors out there have nowhere near the skills or risk tolerance to evaluate these stocks.

3) You are absolutely correct on the mutual fund disadvantage of not being able to short stocks, having to take huge positions etc. Mutual fund managers also have many advantages and access to certain investments that the average individual doesn’t have as well. The mutual fund argument is almost moot at this point since most of them are simply “closet indexers” as Ed Rempel likes to say, to me the more legitimate comparison is hedge funds.

4) At the end of the day I will take the average return on equities every time and I feel extremely confident in recommending that to people. JT, while I have followed your site and your guest posts “from afar” and I’m fairly certain you can beat the market over time, I am not at all certain that you can show others how to do the same. The Facebook IPO and many other events out there including the fact that HFT now accounts for 70% of the transactions on the stock market tell me that I do not want to be competing with supercomputers, NASA-level mathematicians, and hedge fund managers that have dozens of Washington insiders on their payroll amongst many other structural advantages.

1) Even the most broadly diversified fund holds ~3300 securities, though I understand the willingness to simply take the average. There is still a lot of uncovered ground.

2) I like to think that people are plenty capable of selecting their own investments. Skills can be developed – risk tolerance is likely more difficult. I don’t need to tell someone that purchasing a profitable company for less than it has in cash is a good idea. But getting someone to act is far more difficult.

3) Agreed on closet indexing remark, because it is entirely true.

4) I don’t think the average investor has anything to fear with an informational edge. In general, I think fund size is a larger drag on performance than informational asymmetry, which is really my point here: individuals have an edge on Wall Street.

Thanks for your input, TM. It’s always good to see a passive investor who is at least willing to explore the “dark side” of active management.

Hey, I’m willing to admit that there are smarter guys/gals out there than me that can beat the market JT, you definitely being one of them. I just don’t think there are very many to be frank and honest. When the average US investor is getting a 3.1% annualized rate of return over a 20 year period that seen the market return 9.1%, I think that is an extremely strong message that says the vast majority of us just aren’t very good stock pickers.

Just out of curiosity, how many years have you beat “your index” out of the last ten, and what is your annualized return would you say? Can you consistently beat the market by 1%, or 5%? (Just so anyone reading this is aware, beating the market by 1% is pretty freakin hard for most people, and makes a pretty large difference over a long investment period.)

Warren Buffett says he can make 50% per year on $1 million – and I believe him. He did it, so there’s no reason not to. Personally, I think the optimum fund size is probably $50-100 million, which gives you enough leverage on small cap companies to make changes to the board/executives. I know having more capital would make it easier to force changes that you want to see (returning cash to shareholders, for example).

Finding an index for an undiversified portfolio like mine would be nearly impossible. There hasn’t been a year that I’ve lost to the S&P 500, for what that’s worth. Immediately available information in my brokerage account shows 60% last year, and I’m up roughly 20% this year. (Switched brokerages ~2 years ago.) I concentrate heavily, and invest only in companies that have the potential for a buyout. Last year I had more than 50% of my capital in a single company at one time. When there’s an opportunity of that magnitude, there’s no reason to diversify away. I like a portfolio best with 8 companies – it’s my sweet spot.

On amounts of less than $10 million, beating the broad market by 5% per year should be a relative cakewalk.

I log my picks now on an annual basis as part of the different stock picking competitions out there. My picks always mirror what makes up the overwhelming majority of my portfolio. And I tend to stay in companies for just over a year – ideally less, but typical holding time is just over a year…maybe 18 months on average.

2011: CNU, MDF, WTT, ADGF
2012: ADGF, F, DAR, RIG

I’ll keep logging my positions each year for forward testing, since no one has any reason to believe what I say for past performance.

I love Warren Buffet, but there was a period of time where old Uncle Warren pulled all of his capital out of the market and he wasn’t as sure about things as he is now. I think you have an interesting point about the ideal fund size, and there is no doubt that this ability to help manage companies has also given guys like Buffet a large advantage.

I have read the different value investing articles before. Ed Rempel (a Canadian active investing supporter) is fond of quoting the same study. I understand the idea, and if everything else was equal I think I could get on board with the strategy. HOWEVER everything else is not equal (as I previously stated).

You have developed an interesting niche strategy that relies on your expertise in a certain market. While playing the buyout game might have worked so far, you have to admit that you are playing a very speculative game involving micro-cap stocks. Even if we agree that you can play this game good enough to beat S&P 500 returns by 10% every year (even though the Russell 2000 might be a more relevant index for you – although still not a good fit I agree), how many people can replicate what you’re doing with speculation on the buyout statuses of micro-cap companies in certain industries. I’m going to say less than 1%, possible substantially less than 1%.

Now ask yourself how many people can implement a good passive investing strategy (and there are several that aren’t very good) with 2-3 hours of research (reading a certain eBook I highly recommend would be a good start)? I would say 98%+. So that is my argument against doing what you recommend. Saying that the average investor with under 10 million should be able to outperform by 5% just doesn’t hold water. You are not an average investor, and to achieve 15% average returns on a long-term basis is fairly extraordinary by any measure I’ve seen.

“that have dozens of Washington insiders on their payroll” – well said, and I think that the Washington revolving door will likely be slammed shut (isn’t that something Chuck Norris can do?). Basically, those with any amount of time on the hill are coveted prizes for hedge funds, mutual fund firms, and company boards because they can navigate the backrooms of DC much better than most of us.

That said, I personally like to stay away from the corners of the market which have the most political interference – it’s a big market and not every company has an insider in their pocket (or working against them). Al Gore on the Apple board, anyone?

That’s some amazing investing! You remind me of Warren Buffett. Your holdings are like his “cigar butts”. He did not believe in diversification. He sometimes would own only 1 stock. If the cash profits were high enough, the risk is low. He owned 1 stock at one point where the cash profits for only 2 months equaled the price to buy the entire company.

Your characterization of mutual funds is not very accurate, however. Not nearly all have the same stocks as the index and most do not have billions.

Two Yale researchers studied exactly the issue you mentioned. Their study on “Active Share” looks in detail at the holdings of mutual funds and scores them based on their degree of difference from the index.

In Canada, the rated 70% of mutual funds as “closet indexers” – funds with holdings similar to the index. Many fund managers do this to preserve their jobs. I agree with you completely, JT, that nobody should own them. Why pay fees to own the same stocks as the index?

The in-depth study of these Yale researchers showed that the more different the holdings in a fund are from the index, the more likely the fund would beat the index.

For funds with a high “Active Share” with holdings 80% or more different than the index, the average fund beat the index after all fees – and the outperformance persisted.

This actually makes sense. The true stock pickers with the confidence to own stocks very different from the index, like you JT, have no major issue beating the index.

They found that in Canada 20% of funds were moderately different with returns similar to the index, and 10% had a high Active Share and beat the index.

In the U.S., it is very different. 40% have a high Active Share, 45% are moderately high, and only 15% are closet indexers.

The size of funds is not that huge either. Morningstar shows the average & median size of funds in these categories is:

Category Average Fund Median Fund
Canadian Large Cap $275 million $44 million
Canadian Small Cap $118 million $51 million
Global Large Cap $125 million $27 million
Global Small Cap $163 million $33 million

These funds are not too large to own microcap stocks if they want. Half of Canadian funds are under $50 million and half of global funds are under $30 million.

There are quite a few small cap funds and a handful of microcap funds.

You are right that investing in smaller companies generally outperforms over time. A few of the microcap funds have very good long term returns. Almost none of them try to mirror any large cap or small cap index.

The rules of mutual funds don’t restrict them much. The main limitation is not owning more than 10% of any stock (at cost) in their fund and not owning more than 10% of the shares of any company. These are not usually an issue, except for large Canadian equity funds.

In short, you do have some competition in microcap investing. You may not see them much, since small cap and microcap funds tend to trade much less than large cap funds.

Your returns are still very exceptional, JT. Keep up your research and keep up the good work.

Yes, cigar butt-style investing is my number one goal. It’s literally free money, but difficult to find. Otherwise, simple multiple expansion is my favorite play in the small cap space. A two-month price-earnings multiple is asinine, but I’m sure those kind of deals have existed on plenty of occasions. And of course, diversification only limits expected return. No one would point fingers at Buffett for putting 75% of his net worth in GEICO when he did. It was probably one of the best moves of his life – and he even leveraged to the tilt with a bank loan to do it.

Thanks for shedding some light on the mutual fund industry. It’s interesting to learn that Canadian funds can differ significantly more from the index than American funds thanks to the different diversification requirements, yet Canadian funds are less likely to look like the index than American funds. You hit on the gorilla in the room: it’s all about keeping your job. This is most evident to me in academic finance where volatility is treated as pure risk. To an asset manager living on fund management fees, volatility is risk. To his clients with retirement or savings goals – volatility is not as important. It is here that we find the worst example of a principal-agent problem in finance.

Again, thanks for sharing the data that you have. If you have a link to that Yale study, please do post it. I’d like to take a look at it.

The fund industry is the other way around. In Canada, 70% of funds are “closet indexers”. In the US, they are far more diversified and most managers are real stock pickers, since only 15% are “closet indexers”.

Closet indexers are “actively” managed funds that are 80-100% similar to the index. For example, in Canada it can be a fund with 3 or more banks in the top 10 holdings.

There has been a rise of closet indexing in the last 20 years, partly because of the media heavily promoting index funds and partly because it protects the fund managers’ job.

The say in the industry is that, “It is better to fail conventionally than to succeed unconventionally.”

The issue is that if your holdings are very different from the index, then you risk having a time when you underperform significantly. Fund managers can avoid this by keeping their holdings similar to the index. That way, they only lose money when everyone else does.

However, closet indexers are probably the worst investment choice. Obviously they will underperform the index because the holdings are similar and there is no chance to earn their fees. You are not getting real active management, but you are paying for it.

There have been many articles about how the average fund manager underperforms the index. Typically, the reason given is fees.

However, the real reason the average fund underperforms the index is the high proportion of closet index funds. In Canada, 70% of mutual funds are closet indexers that don’t even try to beat the index.

The 30% that are different from the index generally beat the index.

The measure is called “Active Share”. A low number below 20 is a closet indexer. A moderate number between 20-80 is not bad. Funds with high active share are between 80-100.

The study by the Yale researchers is that the average fund with high active share beat the index and this outperformance tended to persist. For example, funds that beat the index over the last 3 years and also had a high active share generally also beat the index the next 3 years.

I have read a lot of studies and articles about investing and found this one to be the most in-depth study of passive vs. active fund management.